RISK MANAGEMENT

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Risk Management

In the financial world, risk management is the process of identification, analysis, and acceptance or mitigation of uncertainty in investment decisions. Essentially, risk management occurs when an investor or fund manager analyzes and attempts to quantify the potential for losses in an investment, such as a moral hazard, and then takes the appropriate action (or inaction) given the fund's investment objectives and risk tolerance.

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Risk is inseparable from return. Every investment involves some degree of risk, which is considered close to zero in the case of a U.S. T-bill or very high for something such as emerging-market equities or real estate in highly inflationary markets. Risk is quantifiable both in absolute and in relative terms. A solid understanding of risk in its different forms can help investors to better understand the opportunities, trade-offs, and costs involved with different investment approaches.

Key Takeaways

  • Risk management is the process of identification, analysis, and acceptance or mitigation of uncertainty in investment decisions.
  • Risk is inseparable from return in the investment world.
  • A variety of tactics exist to ascertain risk; one of the most common is standard deviation, a statistical measure of dispersion around a central tendency.
  • Beta, also known as market risk, is a measure of the volatility, or systematic risk, of an individual stock in comparison to the entire market.
  • Alpha is a measure of excess return; money managers who employ active strategies to beat the market are subject to alpha risk.